Tuesday, November 18, 2008

Today's "trend that will stick": writing down housing values and mortgages to reality will be resisted by lenders, homeowners and government every step of the way, lengthening the recession.

Why will this resistance lengthen the recession/depression? For what happens when writing down bad debt (uncollectable debt, debt based on impaired assets, etc.) is resisted, we need only look at Japan 1989-2002 for an example: hiding bad debt and acting as if assets will rebound to bubble heights someday leads to decades of stagnation.

Since borrowers are still on the hook for the "zombie loans" (loans which are not being paid down but which are kept on the lenders' books at full value), then borrowers can't clear the debt and interest payments off of their ledgers and start rebuilding their capital. The lenders are similarly hobbled; no one trusts them, knowing full well that assets worth 30 cents on the dollar are still being valued at a full dollar on their balance sheets.

The broader economy and government tax receipts both suffer as velocity of lending, borrowing, investing and spending all shrivel in this atmosphere of false numbers, false hopes and false values.

It is difficult to measure this trend, as everyone involved has a keen interest in playing for time, hoping against hope that a resurgence of bubble-era valuations saves them from writedowns, insolvency and bankruptcy.

Unfortunately, popped bubbles no longer hold air. You can blow and blow and blow and they never reinflate.

Let's examine how each player resists admitting to this painfully obvious reality: the assets are no longer worth anything close to their original value.

1. Homeowners. Those with negative equity and insufficient income to pay their mortgages are bailing out because they have no choice, but many others cling on to the hope that their house will some day return to its bubble-era valuation and they can sell out--maybe even for a modest profit.

Kenny Rogers, a data security specialist, moved into Mountain House last year, buying a foreclosed property on Prosperity Street for $380,000. But the decline in values has been so fierce that he too is underwater.The Martinezes bought their house in early 2005 for $630,000. It is now worth about $420,000. They have an interest-only mortgage, a popular loan during the boom that allows owners to forgo principal payments for a time.But these loans eventually become unmanageable. In 2015, Mr. Martinez said, his monthly payments will be $12,000 a month. He laughed and shook his head at the absurdity of it. "

Even when faced with the cold reality of an impossibly gargantuan monthly payment, Mr. Martinez basically shrugged it off; he's staying put and hoping for the best.

"This must be the bottom" investors/speculators like Mr. Rogers also have strong motivations to hang and hope for a resurgence of valuations. "Catching the falling knife" (i.e. buying an asset on the way down) is painful, and human nature is such that bottom-fishers are loathe to admit they got in too soon. Rather than bail out as losses mount, they tend to hang tight and "hope for the best."

Anecdotally, almost everyone involved in real estate (owners, realtors, lenders, etc.) is exhibiting a strong preference for denial as an operating strategy.

It reminds me of the bubble top in 2006 in many ways. Every time I warned a friend that the market was poised for a huge decline and now might be a good time to sell, the response was the same: property here in X won't go down, it has longterm value.

Now when I tell friends to prepare for a 4-5 year depression in which incomes and asset valuations will continue sliding, they nod their heads much as they did in 2006, as if to say, that doom-and-gloom stuff is always overdone; everything will pick back up next year.

A prime reason for this resistance is the alternative--financial ruin awaits--is just too painful to contemplate. Those of us who have lost a bundle in a declining stock market know the drill all too well: we are loathe to take a 20% loss, which then becomes a 50% loss, which just depresses us further, and so we sit by frozen until it becomes a 90% loss. Now it's too late to preserve the capital that still remained when the loss was only 20%.

A great number of people are heavily invested in the idea that their homes and investment properties will bounce back for this reason: their real estate comprises the overwhelming majority of their assets. If housing doesn't pop back up, they will literally have no assets. For Baby Boomers, this possibility is often too terrifying to contemplate.

Another reason people resist accepting their house can decline in value is that they're devoting 50% or more of their earnings to their mortgage and property taxes. The commitment they're making to support their housing asset is crippling; when over 50% of your earnings going into your house, the possibility that you're forgoing everything else in life to pay the mortgage and taxes is wrenching.

As bubble-era house prices shot up, many buyers willingly accepted mortgages which ate up 50% of their take-home pay. This chart of California communities indicates that up to 25% of households are spending 50% or more on housing:

Low-income households often have to pay 50% or more to rent homes in high-cost areas such as coastal California, but the reality is that many homeowners also devote 50% or more of their earnings to housing.

Are the sacrifices this requires worth it? To say "no" is to accept a terrible blow to one's hopes for financial success and perhaps also to one's ego.

2. Lenders. There's no mystery why lenders are anxious not to accept realistic valuations on the mortgages they hold: if they did, most would instantly be declared insolvent.Japanese banks played the same games during their 15-year long "Lost Decade." Some even loaned money to defaulted borrowers so they could make nominal interest payments on the original debt, thereby enabling the bank to maintain the fiction that the loan was in good standing.

We see the same sorts of legerdemain being played by U.S. lenders: for instance, rewriting mortgages at 3% interest only so the borrower can "afford" to make payments. The lender can then maintain the balance sheet fantasy that the mortgage is still worth its original valuation.Those financial entities which own mortgage-backed securities are equally resistant to accepting writedowns, as this article outlines: Investment groups resist mortgage changes:

At the center of today's economic and credit crisis is the rising tide of home foreclosures, which government agencies and some large banks are trying to address by allowing borrowers to modify their mortgages.

But their efforts are likely to fall short because those entities don't control most of the nation's worst-performing loans. Instead, investment groups worldwide do, and representatives of some of them have been resistant to making such changes because it could crimp returns.

All of this is an unfortunate legacy of the trend in recent years of banks selling most of the mortgages they originated, rather than keeping them in their loan portfolios. The buyers, including Fannie Mae, Freddie Mac and Wall Street firms, would then repackage them into securities sold to investors worldwide.

CHS note: "unfortunate" now, but at the time, Wall Street was delighted to sell risky mortages as AAA-rated wonderfulness for billions of dollars in fees. Congress was equally delighted to look the other way, as its hand was in the till.

Today, about 80 percent of the $1.8 trillion in outstanding troubled mortgage loans belong to investors, according to Deutsche Bank. The rest are considered "whole loans," held by banks or government-run mortgage giants Fannie Mae and Freddie Mac.What's clear is that contract law is preventing the companies from easily or quickly bending on this issue (renegotiating or writing down mortgages), and the government to date hasn't done anything to compel them to act differently."

3. Governments. And why wouldn't government want all the bad debt to be repudiated, written down and settled as quickly as possible? Such a writedown would result in many banks and lenders being declared insolvent, and the government would prefer to maintain the illusion of solvency in the hopes that housing will recover and save the banks from insolvency. That would be less messy than having to confess the politicos and agency chiefs had done nothing to protect the public interest during the bubble, and cheaper than having to bail out the entire banking and mortgages industries.

And let's not forget the windfall of property taxes that the housing bubble generated for local government and its public union workers. This chart only reflects the increases from 2002 to 2004; the leaps to 2006 valuations were much higher:

Here's a snapshot of Florida's ski-jump in assessments:

The stunning rise and ensuing collapse of tax revenues is a subject I've covered over the past 3 years, for instance: Post-Bubble Blues: Derailing the Property Tax Gravy Train (April 6, 2006) and Bubbling Property Taxes (April 13, 2006).Thus it is no surprise to find government at all levels climbing into the comfy bed of hopeful thinking/denial along with lenders and borrowers, for local government budgets are already running crimson with the post-bubble declines in property and sales taxes and the fall-off in capital gains taxes reaped from all those successful "flippers" who bought and sold on the way up.

There is a terrible irony in the fact that wishful thinking and resistance to writedowns will only make the decline more painful for all involved. By putting off the day of reckoning, participants are only insuring the decline in valuations and assets will be even deeper, as the steady erosion of values will have no discernable end.

If a global writedown of all impaired real estate assets could be forced now, the rebuilding of capital and trust could begin right away. But the trend to resisting writedowns and losses is firmly in place, and there is little evidence that any participants want to reverse this pernicious trend anytime soon.

Gavril M.I enjoyed the piece. I wanted to tell you that a similar experience was done in Budapest about 35 years ago. I saw it on TV when still in Romania, (we were watching the Hungarian TV). So what they did was to place one of the top classical music students to play the violin on a crowded street corner during the morning rush hour. Filmed him with a hidden camera.For a while nothing happened few people threw him a coin or two. Then an old man stopped. Asked him questions like: Who are you, the violinist answered I am just a gypsy beggar, where did you learn to play like this? and he says my father taught me... you should know that gypsies (roma) are nomad people that are very good musicians and many of them work as musicians in pubs or at various celebrations like weddings (but never made it to a concert hall). Many gypsies live in that part of Europe.

But back to the story, so the old man is staring an saying: Unbelievable, unbelievable... Meantime other people stop and listen, and soon enough a small crowd gathers. Not necessarily music lovers but curious to see what is it all about. The old man is still trying to figure out how is this possible and keeps asking questions. Then somebody intervenes and tries to question him. Why don't you leave him alone, he is only trying to make a living. Are you a policeman or something?

Then the crowd splits, one half trying to protect the begger the other being on the part of the old man. Soon enough a real policeman appears and asks everybody to move on. They were creating a trafic jam. Then he sees the violonist and tells him to beat it.

The epilogue was that both of them, the old man and the music student were interviewed afterward on TV and everybody had a good laugh. The conclusion was that one way or another quality art finds its way and gets noticed.Another time, another place.Thanks for your interesting blogs."

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